Hello everyone. In today's example that I want to discuss with you today, I will distinguish between basic EPS versus diluted EPS. The case of diluted EPS which we use when there are potential security, is that we can't give rise to issued stock. Which when we issue more stock, we actually will dilute the EPS because of the shares that will be reissued. The idea is not as simple as this because in this case we'll distinguish between those options or rights that can give rise to stock, and those convertible securities like convertible preferred stock, convertible bonds. In the case of convertible securities it's a little bit different and additional complication, because in the case of options or rights it give rise to potential securities, to potential common stock. Actually, the dilutive effect is clear if there is a benefit on exercise of those options or rights, because the denominator is the only one that is affected in the EPS calculation. In the convertible securities, it's a little bit more complicated because now the adjustment. If you assume that those are converted at the beginning of the period, then there is an assumption that whatever I have in preferred dividend could have been avoided. The same thing on the interest on the bonds. What if I assumed that they were converted at the beginning of the period, then I will actually could have saved the interests. That's why in the conversion one it's going to affect the numerator and the denominator as we said. Thus, the calculation and the effect of the dilution will have more complication than in the options and the right. Under the options and the right's method that we use, we use the treasury stock method. While in the convertible securities, we use the if-converted method. Let's illustrate all those ideas in the following example. On December 31st, 2020 Universal Company had outstanding 400,000 shares of common stock. On February 28th actually they issued additionally 36,000. There was on September 1st, 10 percent stock dividend that was declared on July 1st. On September 1st there was a retirement of some of the stocks, 9,000 shares. Each of those will be actually weighted by the number of months that they were outstanding or that they were not outstanding as we said before. There will be an adjustment for the 10 percent of the stock dividend for those securities that were outstanding or were not outstanding before the date of the stock dividend. That is simply what we talked about in the basic earnings per share. The next paragraph. At year-end, there were fully vested incentive stock options outstanding for 30,000 shares of common stock (adjusted for the stock dividends). Now, I'm telling you that 30,000. So that when you go and assume that they are going to be exercised by the beginning over the period, that 30,000 has already taken into conservation the 10 percent. So I'm avoiding the complication for this. I'm just explaining why this between-parentheses phrase is important. The exercise price was $18. Very good. That's the amount that I will take, the 18 times the 30,000. When I use the treasury stock method, I assume that those are the funds that I will buy back. The stock had a market price of 20, and that's where the dilutive effect will happen because the market price is higher than the exercise of the option. During 2021, there were 40,000 shares of 8 percent cumulative preferred stock par value outstanding. The preferred stock was convertible into 30,000 shares of common stock. That is a convertible security, we call it potential security that can give potential rise to some additional common stock. But if I assumed that they were converted at the beginning of the period, then I need to assume also that the dividend will also be avoided. The same thing with the convertible bond, I have an outstanding one million face amount of 10 percent convertible bond issued in 2018 and convertible into 50,000 common shares adjusted again for the stock dividend. I explained why is that important, so that you take the 50,00. It's already adjusted for the stock dividends. The tax rate for the year was 25 percent. Let's see how we're going to go for the diluted earnings per share as we go for the convertible preferred stock and the convertible bond. Let's take a look. Here's the calculation of the basic earnings per share that we went through before, and it's the same calculation with the same weighted average, with the same adjustment to the stock dividend getting basic earnings per share of 1.847. When we go to the dilutive effect or the dilutive EPS, we actually need to take into consideration those stock options that can give rise to additional number of shares. We use the treasury stock method which assume that those proceeds that I will get by assuming the stock options were exercised at the beginning of the period, will be used to buy stock at the average market price of the stock which is the $20. That's why I am assuming that I will issue 30,000, but I can acquire 27,000. So the net increase in the stock market will be 3,000 shares and that's where the dilutive effect. Notice that I did not again make any weighting of this because it's assumed that it is going to be exercised at the beginning of the period. Notice that I actually did not add anything for this here. I'm saying plus and missing. There's nothing added in the numerator, because there is no dividends or interest that can be avoided because of those stock options. It's just giving rise to a net increase in number of shares. Let's take a look at the convertible preferred stock. Here, those are convertible into 30,000 shares and that's why in the denominator I assumed preferred stock conversion. Again, there is no weighted adjustment here because it's assumed that they're converted at the beginning of the period. Had they been converted at the beginning of the period, I would not have paid the preferred dividend and that's why that is an adjustment to the numerator and the denominator. That is why that is coming to be as a dilutive effect. Very good. When we have the convertible bonds, because they are convertible into 50,000 shares there is there assumed conversion. Fifty thousand shares are assumed to be issued. Actually, have I assumed that it was converted at the beginning of the period? What if I would have saved the interest on this? That's the 1,000 or the one million times 10 percent, times 1 minus T because it is after the tax savings on the interest. Those are the interests that could have been avoided after taxes. That's where I'm saying that if converted method is assuming that those convertible securities are converted to common stock at the beginning of the period, and finally I'll have a diluted earnings per share of 1.763. That is obviously lower than the basic earnings per share because of the dilutive effect of those options, or the convertible securities whether there are preferred stock or convertible bonds. Hopefully, this example illustrated the idea of the difference between basic and diluted in a more collective way to take the difference between the treasury stock method and the if-converted method that we use in the convertible security. Thank you very much.
